Extremes This Time Are Good

If one watches CNBC or CNN for any length of time he would likely come away thinking that the stock market is on its final legs, and for good.  When things are bad, it seems that those who are best at pointing out how bad things are and could become, get the bear’s share of the spotlight.  Granted, there is plenty of bad news out there, but the good news is not getting through the dense bad fog.  A significant part of the good news is that many of the extremes being reached in today’s stock and bond markets are actually positive signals for better times ahead. 

One of my favorite indicators of market action is the number of NY Stock Exchange stocks trading above their 200-day moving average.  The index has reached lows of 20% only five times in the past ten years.  Three of those occurrences have happened within the past thirteen months.  With the exception of the dip in July to 19%, and today’s level of 19%, markets have risen substantially in the months following these selling climaxes.  Similarly, according to Bloomberg as of yesterday, 1,348 stocks made new 52-week lows while only 52 reached new highs.  These are signs of a market bottom, but just when market improvement will occur remains illusive.

Don Hays says this is the most complex market bottom he has studied in his long (and successful) career.  He continues, saying “for that matter the topping action from November 1997 to March-July 2000 was the most complex top in history, so I suppose the bottom should be as well.”

A recent article by Caroline Baum of Bloomberg features comments by Joe Carson, an economist at Alliance Capital Management in which he notes that nominal (not adjusted for inflation) gross domestic product rose 3.2% in the four quarters ended in the second quarter of 2002 “the fifth consecutive quarter nominal private-sector GDP rose less than 3% year over year.”  Carson points out that “we’ve never had five periods of below 3% growth in the entire post-World War II era.”  In other words, with nominal growth advancing at a crawl, it feels as if the economy is idling.

Baum adds that Jim Glassman, senior U.S. economist at J.P. Morgan Chase, looks at the current anemic growth a bit differently.  Because of strong productivity growth, “the U.S. economy may need to grow at 4% to bring unemployment down, a much higher bar than in the past.”   The unemployment rate has started to fall, dropping to 5.6% in September from 5.9% in July.  Economists fully expected to exceed April’s 6% peak.  Instead, based on the Bloomberg’s survey of households, employment growth soared by more than 1 million jobs in August and September.

Other economic news this week has been positive.  The pace of job loss is declining.  Initial jobless claims were 26,000 below expectations and 33,000 below last week.  Imports were up .7% compared to .3% last month, indicating continued consumer appetite for foreign goods.  The Producer Price Index rose just .1% showing that inflation at the manufacturing level is non-existent.  Advance retail sales less autos showed a slight increase of .1%.

On the negative side, the University of Michigan Confidence declined further than expected, coming in at 80.4 vs. an 85.5 estimate by economists polled by Bloomberg.  Earlier in the week we saw consumer credit fall much more than economists expected.  In August it was at $4.2 billion versus $10.8 billion in July.  Consumers are using their mortgage refinancing proceeds to reduce debt rather than spending most of it, as in the past.

With all the pain of the stock market, investors are rushing to bonds now like they were rushing to stocks in the late 90’s and early 2000.  But do they have any better idea of what they are getting into now than they did when they were buying tech stocks at any price?  Caroline Baum notes that an Investor Literacy Test conducted by the Vanguard Group, the second-largest U.S. mutual fund firm that nearly 70% of the 1,000 randomly selected investors surveyed “did not understand the inverse relationship between bond prices and interest rates,” according to a press release posted on the company’s Web site.  They have no idea of the interest-rate risk either.

U.S. mutual funds saw a $104 billion net inflow into taxable and tax-exempt bond funds through August of this year, according to the Investment Company Institute, and many of them had no idea what they were getting into according to Caroline Baum.  Vanguard has tested investor literacy every two years for the past eight years.  The average score (100 is perfect) was 51% in 1996, 49% in 1998, 37% in 2000 and 40% in 2002.  Bull markets peaks are marked by manias, which draw in many new and inexperienced investors.  The current Bull market in bonds may be no exception.

What investors know is that bonds — especially ‘risk-free’ Treasuries — continue to soar while yields tumble and stocks move relentlessly lower.  The S&P 500 is down 31% year to date, a 5 1/2-year low.  According to Bob Barbera, chief economist at Hoenig & Co. in Rye Brook, New York 

“behavioral economists would say that the madness of crowds is more important than the mean expected value of outcomes.  The enthusiasm for Treasuries at miniscule yield levels is not unlike the conviction about stocks in early 2000.  [Then], you could have made rational calculations that the future implied by the financial markets was extraordinarily unlikely.  “A similar calculation can be made today. Whereas at the start of 2000, the markets were projecting “real growth above 4% into perpetuity, now the projection is for nominal growth well below 4%.”  The former forecast proved misleading and today’s glum outlook, reflected in depressed Treasury yields and stock prices, will turn out to be equally off base.”

Through the madness of crowds investors seem, temporarily, to have abandoned the long-term benefits of equities.  Stocks, as you know, trade on future expectations of their companies’ earnings growth.  First Call, which samples the majority of equity analysts on Wall Street, estimates that earnings growth for the third quarter will come in at a sluggish 5.9%, but they estimate the fourth quarter will show a more healthy 19.5% rate of earnings growth.  The percentage of companies coming in below their estimates is running at 54% so far this year compared to 63% last year.  The ratio of negative to positive announcements is 2.6 now compared to 5.7 last year.  Earnings are getting better and the market is forming a bottom.  If the earnings recovery is real, the stock market will begin to anticipate it soon.

Sam Bass
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